Preemptive Investment under Uncertainty

TL;DR

This paper characterizes subgame perfect equilibria in strategic timing games where two firms decide on irreversible investments under uncertainty, revealing how uncertainty influences equilibrium outcomes and introducing Pareto improvements.

Contribution

It provides a general framework for analyzing equilibria in investment timing under uncertainty, using a novel reduction to constrained optimal stopping problems.

Findings

Uncertainty can lead to qualitatively different investment behaviors.

The analysis identifies additional equilibria that improve Pareto efficiency.

The framework applies to typical state-space models, enhancing existing equilibrium arguments.

Abstract

This paper provides a general characterization of subgame perfect equilibria for strategic timing problems, where two firms have the (real) option to make an irreversible investment. Profit streams are uncertain and depend on the market structure. The analysis is based directly on the inherent economic structure of the model. In particular, the determination of equilibria with preemptive investment is reduced to solving a single class of constrained optimal stopping problems. The general results are applied to typical state-space models, completing commonly insufficient equilibrium arguments, showing when uncertainty leads to qualitatively different behavior, and establishing additional equilibria that are Pareto improvements.